Federal Deposit Insurance Corporation
Bank Administration Institute
December 11, 1996
One of the benefits of spending time here in the nation's
capital is that one is constantly reminded of the continuing ties
between the present and the past. From the windows of the Federal
Deposit Insurance Corporation, for example, one can see both the
lawn where President Lincoln walked -- and the far banks of the
Potomac where Confederate flags flew. The building next door to
the FDIC was the War Department then, and it is said that Lincoln
would visit there to receive direct telegraphic reports from the
battlefields. As commanding general of the army for many years
after the Civil War, William Tecumseh Sherman had his office
across the street in the Old State, War, and Navy Building.
Given the immediacy of the past in Washington, history is
not just a subject taught in school here, it is in fact often the subject
of conversation -- and sometimes in surprising ways, as a friend of
mind found out when he was helping his son with his math
homework. After much difficulty, my friend finally said in
exasperation: "Son, you ought to be ashamed of yourself -- at your
age, George Washington was a surveyor."
Without missing a beat, the young man looked into his
father's eyes and said: "Yes, and at your age he was President of
the United States."
Knowledge of the past provides us with a context for the
In that regard, much of the history of banking in this
country is the story of the search for stability. As we all know, the
FDIC was created in 1933 to restore and maintain public
confidence in a banking system that had been shattered by failures.
Interestingly, the Bank Administration Institute itself had its origin
in the response to one of the catastrophes that periodically roiled
the financial system before the FDIC was created -- the Banking
Panic of 1907. In response to that panic, banks began creating
internal auditing departments to help ensure their solvency. Bank
auditors formed BAI -- known in the first quarter-century of its
existence as the National Association of Bank Auditors and
Comptrollers -- to exchange information that could be used as
auditing standards for banks.
Banking panics were terrifying experiences that seemed to
grow in force from one to the next, until nine thousand banks failed
in the banking crisis of 1929-1933.
In speaking to bankers in New York City in 1938, FDIC
Chairman Leo Crowley said: "Deposit insurance came into
existence because more than $3.5 billion of depositors' funds were
dissipated during the years between 1865 and 1933. No banking
system with the weaknesses this record indicates can expect to
maintain the confidence of bank depositors." Congress, he said,
had two choices to restore public confidence: deposit insurance or
nationalizing the banking system. The lawmakers opted to support
private enterprise, he stressed, not to eliminate it.
In 1934, the year following the creation of the FDIC, nine
insured banks failed.
Over three generations, federal deposit insurance has
prevented banking problems from becoming banking panics, and in
doing so it has stabilized an inherently unstable financial system.
The nation has benefitted in three ways. First, federal deposit
insurance has brought peace of mind to tens of millions of
depositors, who no longer had reason to fear the failure of their
banks. These were -- and are -- small depositors who are less likely
to have the resources and expertise to assess the financial strength
and policies of the banks with which they do business. Second,
when banks suspend operations, the payments system is disrupted.
By preventing bank panics, federal deposit insurance allows
payments to clear among numerous parties in an orderly and
efficient manner, thus preserving the integrity of the payments
mechanism, without which no modern economy can function.
Third, by insulating banks from panics, deposit insurance helps
bring stability to the conduct of monetary and fiscal policies.
No one, however, repealed the business cycle. The failures
of more than 1,400 U.S. banks from 1982 through 1994 -- apart
from the 1,250 savings and loans that failed during the same period
-- reminded us that guaranteeing savings can be a costly business,
although it may be necessary to stabilize the banking system in
times of stress.
We do not have to return to the 1930s -- or watch the film,
It's a Wonderful Life, that is popular this time of year -- to
understand how traumatic a run on a bank can be. In early 1991 --
just six years ago -- the New York Times described events at the
Bank of New England in this way:
"Frantic depositors pulled nearly $1 billion out of the bank
in two days; small savers trooped through the lobbies with their
money in wallets, bulging envelopes and briefcases, and money
managers yanked out multimillion-dollar deposits by remote control
with computer and telex orders.
"Some local crooks even tried to get in on the action. The
Federal Bureau of Investigation said it foiled a plan by six men who
had hoped to rob an armored car they figured would be loaded with
cash for all the withdrawals.
"Yet as soon as Washington stepped in, with the Federal
Deposit Insurance Corporation taking over the bank on Sunday, the
panic subsided," the Times concluded.
The Bank of New England case underscores how rapidly
public confidence can evaporate. It also underscores the
importance of deposit insurance in maintaining public confidence in
the banking system. Bank of New England customers may have
had doubts about their bank -- but their doubts were not
contagious. A run on the Bank of New England did not spread into
a general banking panic, with depositors at other banks demanding
their funds, too.
We have evidence that throughout the banking crisis of the
late 1980s and early 1990s, federal deposit insurance was the
anchor for public confidence in the banking system. For example,
in 1989 the American Banker commissioned Trans Data
Corporation to survey 1,009 adults throughout the continental
United States on confidence in banking. The survey found that 95
percent of the survey respondents said that it was important to them
that there be a federal deposit insurance fund -- and nine out of 10
of the respondents expressed confidence in the current insurance
system. When asked what they would do with their money if there
were no deposit insurance, 36 percent said they would keep it at
home. Twenty-one percent said they did not know what they
would do. Only 18 percent said they would keep their funds in
In recent years, however, a question has arisen as to who
can do the better job at guaranteeing bank deposits -- the
government or the private sector? Indeed, the BAI has taken the
position -- in a report on regulatory reform prepared for you by
McKinsey & Co. -- that the FDIC should be "privatized."
Tonight I want to address (1) privatization of deposit
insurance in general, (2) why the BAI/ McKinsey plan would not
attain the results it desires, and (3) why the plan is based on a
misconception regarding deposit insurance and the causes of moral
hazard. I will then discuss how the FDIC is addressing the problem
of excessive risk taking that can arise from the moral hazard of
Let's turn first to deposit insurance in general.
In giving us a context for the present, the history of private
deposit insurance and other such arrangements that lack the "full
faith and credit" of the federal government is not reassuring. In
fact, it is the history of failure. Private and state-sponsored deposit
insurance schemes have been tried -- and found wanting. As
recently as 1982, there were 32 deposit insurance funds in
operation. Only eight survived the crisis of the late 1980s and early
1990s -- and these survived because none of their significant
members failed. Six operate today, but three are limited in scope
and three cover state credit unions. Almost all the other funds
collapsed because of the failure of one or more insured institutions.
Most of the funds were state-sponsored, although the state did not
usually provide any financial guarantees to the fund. These funds
typically were mutual insurance funds with a board of directors
drawn from the insured institutions.
Deposit insurance can prevent banking panics only if
depositors have confidence in the insurance plan. To inspire
confidence during a period of turmoil, deposit insurance must -- as
far as the insured depositor is concerned -- be comprehensive. The
problem with private plans developed thus far is the limited pool of
resources on which they can draw, as compared to the unlimited
pool of resources of the federal government. Private insured funds
could be designed to handle isolated failures successfully, but they
are likely to have difficulty handling catastrophes. Bank failures
may come in waves, however, because the performance of the
banking industry is closely tied to the performance of the economy.
Further, during a crisis, a private insurance fund would have to seek
financing from the banking industry or other private sources of
funds when the whole industry -- and perhaps the economy -- are
already in financial trouble. The price of a substitute for the "full
faith and credit" of the federal government in inspiring public
confidence would be prohibitively expensive. The serious question
to grapple with in any privatization proposal is: How much less
than the equivalent of a full faith and credit' guarantee by the
federal government will the public accept -- and how much less
would fully protect the banking system in times of crisis?
Let us turn now to the BAI/McKinsey plan.
The plan would privatize the FDIC and replace the line of
credit from the U.S. Treasury with a private bank line. It is driven
by a desire to free the banking industry from legal and regulatory
constraints on its operations.
Any successful private deposit insurance fund, however,
would have to monitor, if not regulate, bank activities. Virtually all
insurance policies -- health, life, and liability -- contain restrictions
and limitations on coverage, as well as conditions on approval, in
order to control risks. A bank's loans and other activities
determine the health of the bank. An insurance fund could not
appraise the risk of insuring a bank's deposits without conducting
its own bank examinations, and it could not limit the risks without
restricting bank activities. Such a plan would simply substitute
government regulation with private regulation by competitors.
The proposal raises the whole point of the proper
constituency for any insurance fund. It makes quite clear that the
BAI's proposed fund is to be run by banks for banks. However,
deposit insurance is insurance for the depositor. If the operation of
the fund were unsatisfactory, depositors have only one recourse --
to take their money out of the banks -- which could lead to the sort
of bank runs that the FDIC was founded to prevent.
Fundamentally, the BAI/McKinsey plan rests on a
misconception -- that moral hazard created by federal deposit
insurance can be eliminated through privatization. Any deposit
insurance fund -- any form of insurance, in fact -- faces the problem
of moral hazard, regardless of its ownership or management. The
problem of moral hazard occurs when insurance induces the insured
to take more risk.
With deposit insurance, the insured party is the depositor.
Insurance permits depositors to ignore the condition of their banks,
so even fundamentally unsound banks may have little difficulty
obtaining funds. Because insured depositors no longer have an
incentive to monitor and discipline banks, bank managers may take
more risks than they otherwise would. Deposit insurance can
create opportunities for managers to make high risk/high return
investments, without the market discipline of having to pay
creditors to take that risk.
Historically the moral hazard problem created by federal
deposit insurance has been mitigated by banking regulation and
supervision and by insulating banks from competition -- one
explanation for the low number of bank and thrift failures for
almost 50 years following the creation of the deposit insurance
system. Among the regulatory actions that reduce the risk arising
from moral hazard are capital standards, examinations, and
Capital serves as a deductible for deposit insurance. Initial
losses fall first on the equity investor, not the insurance fund.
Capital standards give bank owners incentives to minimize risk.
Only if losses exceed capital will they be borne by others. Because
insured depositors do not need to look at the credit quality and
other features of their banks, examinations act as their surrogate.
Safety and soundness regulation is intended to be a substitute for
market discipline. The 1980s -- particularly in connection with the
savings and loan crisis -- reminded us that, without effective
supervision, deposit insurance can simply become a public resource
that risk takers can exploit. The challenge to the regulators is to
develop safety and soundness regulation that comes as close as
possible to market discipline. We are not there yet, but I remain
Our objective must be to strike a balance that minimizes the
moral hazard of deposit insurance, while providing stability to the
banking system. As you know, to address the problem of moral
hazard and to discourage excessive risk-taking, a number of
reforms have been initiated in the past few years, including
risk-based capital standards, as well as higher minimum standards for
prompt corrective action; risk-related insurance premiums; the
least-cost test for resolving bank failures, and national depositor
The development of internationally-accepted risk-based
capital standards is one of the most significant innovations in the
history of banking regulation. The Basle Committee on Banking
Supervision has laid out a framework for assessing an institution's
capital adequacy by weighing its assets and off-balance sheet
exposures on the basis of counterparty credit risk. Moreover,
recognizing that international banks have been actively involved in
trading securities and derivative products, the Committee has
developed progressive standards through the use of standardized
and internal models to measure the unique market risks of specific
portfolios. As the first financial sector regulator to develop
internationally accepted capital standards based on the unique risk
of each bank, the Basle Committee is a pioneer in developing
internationally accepted supervisory standards.
Higher minimum capital standards, as you know, are
enforced through the policy of "prompt corrective action" when the
capital of troubled institutions erodes. Under the system of prompt
corrective action -- which went into effect at the end of 1992 --
federal regulators are required to begin a variety of supervisory
actions if the capital of an institution falls below strictly defined
minimums. The farther an institution falls below the minimums, the
more severe the supervisory actions become. Those supervisory
actions include -- but are not limited to -- imposing restrictions on
dividend payments and other capital distributions, limiting
management fees, curbing asset growth, and restricting activities
that pose excessive risk to the institution. Early intervention allows
bank regulators to preserve some of an institution's franchise value
and, thereby, to limit losses to the insurance fund. More important,
minimum capital standards and prompt corrective action are
intended to curb excessive risk taking so that regulators will not
have to intervene to close an institution.
The principle embedded in prompt corrective action is
gradation of risk and of appropriate regulatory response: The less
capital a bank has, the smaller the financial cushion for losses, and
the greater the risk it poses to the insurance fund. The greater the
risk, the more attention it should receive from regulators. The
principle of gradation of risk and response is also reflected in our
system of risk-related FDIC insurance premiums.
For almost 60 years, all insured institutions paid the same
premiums to the fund, regardless of the risks they posed. Beginning
in 1993, we divided banks and thrift institutions into nine groups,
depending upon the risks they presented to their insurance funds.
The greater the risk, the higher the premiums the institutions pay.
Part of that risk calculation is based on capital and part on
supervisory factors such as asset quality, loan underwriting
standards, and management. Risk-related premiums promote safety
and soundness -- and help to address the issue of moral hazard -- by
giving institutions an economic incentive -- through lower deposit
insurance premiums -- to improve their conditions and maintain
lower risk profiles. We are analyzing whether other factors are
relevant to risk -- and thereby whether the nine-block grid for
setting deposit insurance premiums should be expanded -- as well
as whether our current 27-basis point spread is sufficient to price
the risks to the insurance funds posed by individual institutions.
One other requirement imposed in 1991 exposes uninsured
depositors to greater loss than before. In resolving bank failures,
the FDIC is required by law to accept the proposal from a potential
purchaser that is the least costly to the deposit fund of all the
proposals we receive. In more than half of the failures in 1992 --
66 out of 120 -- uninsured depositors received less than 100 cents
on each dollar above the $100,000. That was a significant increase
in uninsured depositors experiencing losses from 1991, when fewer
than 20 percent of the failures involved a loss for uninsured
depositors. While the number of bank failures in 1992 was lower
than in previous years, the number of uninsured depositors
experiencing a loss was significantly greater.
Additionally, the passage of a national depositor preference
law in 1993 gave creditors of banks other than depositors an extra
incentive to be concerned about the condition of their institutions.
In essence, depositor preference means that, if a bank fails, anyone
with a non-deposit claim gets nothing until all depositors, including
the FDIC as insurer, have been made whole.
Higher risk-based and minimum capital standards, risk-related
deposit insurance premiums, the least-cost test for resolving
bank failures, and national depositor preference are regulatory
actions that address the risks to the insurance funds and the
taxpayers that arise from the moral hazard that deposit insurance
creates. Conceptually, they and other regulatory requirements are
direct and indirect surrogates for the discipline that depositors
would logically impose if they had access to the economist's dream:
perfect information in a purely competitive market.
Private deposit insurance would have to have similar
surrogates for market discipline. One has to ask whether a
consortium or board of directors of private sector bankers who are
in competition with each other would be able to manage a
disciplined, unbiased system of regulation to offset the moral hazard
of insuring bank deposits, regardless of whether the private
insurance plan offered less than the "full faith and credit" guarantee
of the federal government.
In conclusion, Congress created federal deposit insurance
more than 60 years ago -- not to protect individual banks -- but to
protect the depositor and to provide stability for the banking
system. It was intended to be one of the few certainties in an
uncertain financial world. It would promote the development of a
modern and efficient payments system. It would foster economic
The architects of the system were realists who, in the words
of FDIC Chairman Leo Crowley, saw that "the virtues of our
system of independent banking by private enterprise outweigh its
weaknesses." Private enterprise meant the opportunity to fail as
well as to succeed.
It is probably true that during the banking crisis of the
1980s and early 1990s, the FDIC indirectly protected the
shareholders of failed banks more than could be justified today,
although it is easier to understand that issue with 20-20 hindsight
than in the midst of a full-blown crisis.
The innovations since that time that I have discussed, and others
that the FDIC continues to evaluate, are intended to avoid that
result in the future.
In 1934, Chairman Crowley stressed the point that federal
deposit insurance was an asset for the industry when he addressed
the American Bankers Association just 11 months after the FDIC's
creation. He said: "The recent depression has proved that no group
of banks in any geographical locality is isolated from the banking
situation in the country as a whole. For this reason, it is important
that the protection to depositors which an Insurance Fund makes
possible be conducted on a national scale so that all may enjoy the
same degree of protection."
In placing the full faith and credit of the federal government
behind bank deposits, insurance meant that the banking industry and
the economy would never again have to face runs and panics and
the economic turmoil that resulted.
For banks today, federal deposit insurance remains an asset
-- just as it is an asset for depositors of banks. The principal reason
advanced by advocates of change is that the "subsidy" from deposit
insurance and access to the payments system have prevented banks
from being permitted to engage in a broad range of new activities.
The premises of that argument -- that such a subsidy exists and that,
if it exists, it cannot be removed without eliminating federal deposit
insurance and special access to the payments system, should be
examined and well understood. They are analytically separate
issues from the question of whether the FDIC should be privatized,
Knowledge of the past provides us with a context for the
present. I do not know whether it is true, as the philosopher said,
that those who forget history are doomed to repeat it. It seems to
me, however, that if an institution is created for a purpose -- and
has lived up to all expectations -- it should not be changed without
clear, sound, and well-understood reasons for doing so.